But are political leaders able and willing to co-operate?Oct 11th 2018Print edition | Special report
IN THE DARK days of the Great Depression, the balance of economic terror was measured out in movements of gold from one country to another. Physically, though, the gold more or less stayed put. Most central banks kept their gold in the vaults of the Bank of England. Flows were accomplished by placing gold bars on a trolley and wheeling them from one pile to another a few feet away. Told that the economic cataclysm was the product of too much gold on one side of the vault rather than another, Britain’s ambassador to Germany sighed: “This depression is the stupidest and most gratuitous in history.”
Once again, the world is at risk of bumbling into an unnecessarily painful economic mess. If the next global slump takes a turn towards the catastrophic, it will not be because of a dearth of ideas for how to pry an economy out of a rut. Rather it will be because politicians given a long list of ways to pump money into an economy badly in need of it proved unwilling or unable to choose any. Sadly, such an outcome is all too real a possibility.
Even so, the resulting slump might not prove an utter disaster. Struggling economies might accept their fate with equanimity, much as Japan did in the two decades after its bubble burst. But it is far too easy to imagine how a misfiring global economy could place unbearable pressure on the world’s strained geopolitical sinews. There are many reasons for concern.
The biggest is the simple fact of the financial crisis, looming so recently in the past. Crises are politically toxic. As Messrs Mian and Sufi and Francesco Trebbi of the University of British Columbia noted in 2014, political polarisation and factionalisation almost inevitably follow crises. Voters are more attracted to ideological extremes, and political coalitions grow weaker. The world is awash with supporting evidence. In some places radical parties have found their way into government, as in Greece, where Syriza is now the largest party, or Italy, where a coalition of the populist Five Star Movement and the nationalist Lega is in power. Poland’s Law and Justice party has pushed the country in an ever more illiberal direction since it won a majority in 2015. In many other countries establishment parties have become more radical in response to changing public opinion or to fend off challenges from the fringes. In America and Britain, venerable conservative parties are undercutting the stabilising institutions they once championed.
Weak governments will often struggle to enact the policies needed to respond successfully to a slump in a zero-lower-bound world. Many radical and populist governments seem to lack the deep commitment to long-standing institutions that helped hold together the world economy during the crisis. Then, trust and sacrifice prevented a destructive economic nationalism. Even though individual countries could have benefited temporarily from narrowly self-interested policies, they decided to stand together, avoiding a cascading protectionism that would have hurt everyone. G20 countries agreed in 2009 that all those who could afford it should borrow and spend, which benefited everyone. They promised not to throw up tariff barriers as governments did during the 1930s, and their commitment largely held. Now, though, even before a new slump hits, geopolitical amity is eroding.
The unprepared state of most economies means that co-operation is more important than ever, but also more tenuous. As Brad Setser of the Council on Foreign Relations argues, an economy stuck without recourse to its most powerful monetary tools has two options, with different implications for the rest of the world. It can use fiscal stimulus to increase spending, even though some of the benefits will inevitably flow across borders as people buy foreign goods and services. Or it can depreciate its currency and siphon off expenditure by foreign economies. Among the greatest risks posed by a new recession is that governments may engage in a zero-sum war for spending. Unable to overcome the technical and political hurdles to creating more money at home, they might opt to suck in money from abroad. That fear goes back to the dark days of the 1930s when most advanced economies adhered to the gold standard. It gave them very little room for manoeuvre, so they were unable to use expansionary fiscal and monetary policy to reverse a downturn.
The modern world owes the relative absence of deep depressions to the fact that fiat currencies, unconstrained by gold, allow governments to stimulate economies in times of trouble. But when interest rates fall to near zero and, at the same time, governments find it hard to borrow, economies begin to look similar to those of the gold-standard era.
It is easy to imagine a downturn causing tensions over exchange rates. After the financial crisis China pegged its currency to the dollar, preventing the yuan from appreciating by buying massive amounts of dollar-denominated securities. As a result, Americans spent hundreds of billions of dollars more on Chinese goods each year than Chinese households spent on American goods: a critical drain on American demand at a time when growth remained weak and unemployment high.
China has since moved to managing the yuan against a basket of currencies rather than just the dollar, and its current-account surplus has shrunk to almost nothing. Yet the Trump administration continues to rail against Chinese surpluses and currency manipulation, and has launched an escalating trade war. An economic slowdown in China combined with American monetary tightening could prove explosive. The yuan would drop; indeed, the dollar has risen by 10% against the yuan since April.
As credit conditions around the world tighten, most emerging markets will face pressure to reduce their current-account deficits. They will accomplish this, in large part, by depreciating their currencies against those of advanced economies and the dollar in particular. America’s current-account deficit tumbled after the global financial crisis but has been on the rise again since 2014. Fed tightening and the larger budget deficits created by Mr Trump’s tax cuts practically guarantee that it will continue to grow, meaning that America will export demand to the rest of the world.
That includes Europe. The EU’s current account, which was more or less balanced as recently as 2012, has moved sharply into surplus, thanks to a protracted downturn that depressed European wage growth, monetary easing by the ECB and continued fiscal austerity. The monetary and fiscal restraints binding the euro area are the closest modern analogue to the gold standard; if and when a new downturn strikes, Europe may well face the most explicit choice between depression and heavy reliance on foreign demand.
During the global financial crisis, many economists worried that this economic calamity might have geopolitical consequences like those of the Great Depression. It did not. Yet global politics have changed. The country on which the burden of depreciations will fall most heavily is run by a man who hates globalisation. The greatest threats to the global economy today are political.
When the next downturn comes, politics could well get in the way of a sensible response. China’s brittle government could prove unequal to the task of managing a slowdown. Saving the economy might force Beijing to choose between doubling down on debt-fuelled growth and shifting the burden of a downturn onto foreigners, through export-boosting currency depreciation. The euro area remains vulnerable to a new outbreak of its debt crisis. If Italy were to fall out of the euro area, the ensuing financial panic could dwarf the global financial crisis, and the EU could collapse. America, pushed once more into the role of global consumer of first and last resort, might acquiesce to its president’s desire to dismantle the integrated global economy, ushering in a much more dangerous era of economic nationalism and dealing a huge blow to incomes around the world.
None of these things must happen. None are inevitable consequences of slightly lower growth in global spending. But the world spent the better part of a century learning to tame business cycles and respond to them in ways that minimised the stress on political systems, only to find itself in uncharted waters. The global financial system is more prone to havoc than previously appreciated and its recession-fighting tools no longer pack a punch. Economists and politicians are certainly clever enough to adapt and respond to new challenges. What is unknown is whether world leaders are still confident and committed enough to averting geopolitical havoc to take the action so badly needed.